Pension vs Isa: The big debate

Which is best? We take a look at the merits and minuses of pensions and Isas

Which is better, an Isa or a pension? Over the last few years, it's become the big debate among retirement savers.

Everyone from granny to graduate has a view - but for most of us these days, Isas rule supreme.

And they dominant the savings world for very good reasons.

Ask yourself this: how many ways can you save money, get instant access to your cash, and enjoy protection from the Government's tax-grabbing mitts?

Answers on a postcard please (clue: pensions ain't one of them).

With the amount you can save each year raised to £10,680, a maximum of £5,340 in cash, savvy savers have quickly come to regard Isas as long-term homes for their nest eggs.

But what about pensions? Are they still worthwhile?

A few years ago, the final salary pension was a mainstay of the British workplace. And that certainly was worthwhile. Millions of workers knew they would retire in comfort, which often meant two-thirds of their final income.

But such bounteous company perks have died a ghastly and painful death in the 21st Century. At the last count, just 21 per cent of schemes were still open to new members in the private sector, compared with 88 per cent ten years ago. Around 17 per cent are closed to existing members as well, the National Association of Pension Funds says.

We're left with a barren landscape of 'defined contribution' schemes, where retirement income depends on how much you save and how fast this grows.

And yet around 14m people in Britain still have a pension. There has been a decline in the numbers still contributing with some 8.3million stowing money away last year, according to the Office for National Statistics. But this is largely due to the household squeeze on incomes, experts say.

The industry is still firing on (most of its) cylinders and modern schemes have lower charges. The Government is keen, too, and from 2012 will ask employers to automatically enroll staff into company schemes.

So surely there must be benefits? Right. There are. One is a new ability to inherit your forefathers' savings or pass on yours. You're now able to convert up to 100% of pots into cash once you hit 55 (only for the very wealthy) and leave any unused money to your loved ones on death.

But you've been able to do that with Isas for ages. So back to the big debate - what's the verdict? Isa or pension? We asked five independent experts for the lowdown.

We want you to get involved in the Big pension vs Isa debate, too. What do you reckon? Leave your thoughts in the reader comments at the bottom of this page.

PENSIONS

Pension pros:

- Tax relief

When you pay money into a pension the Government refunds the income tax you paid on it. Effectively, basic rate taxpayers only need to put in £80 to see £100 go into their pot; 40 per cent taxpayers only need to put in £60 to see £100 added (they need to claim back 20 per cent via the taxman). When you draw on your pension you are taxed at income levels again. But in all probability you are going to have a smaller income and usually this means basic rate tax. According to Lorreine Kennedy, an adviser at Care Matters, this could mean you're 33 per cent better off than with an Isa.

- High contribution limits

Pensions have high annual contribution limits of 100 per cent of earnings, subject to an overall cap of £50,000 and a lifetime allowance of £1.5million (from April 2012).

- Employee benefits

Many companies have a staff pension scheme. Lots of these used to be generous, 'gold-plated' final salary arrangements. But now most depend on you sacrificing chunks of your salary and watching a pot grow (slowly).

However, most employers will at least match your pension contributions - some even put in more. So if you contribute, say, 6 per cent your employer might put in another 6 per cent or even 8 per cent. Look at this as a pay rise - it'd be madness to say no.

Work bonus: It's well worth taking advantage of company pensions because your employer will often contribute on your behalf - effectively a pay rise

And as you can save on National Insurance, too. With a pension you can elect for a salary sacrifice which will allow you to avoid National Insurance of 11 per cent. So a basic rate tax payer could have tax relief at 20 per cent on the contribution, plus 11 per cent national insurance saving. An Isa doesn't have any of these tax luxuries.

- Tax-free growth

Virtually tax free growth within the fund. That should mean your money's safely stored away from the Government's prying eyes. Pension funds did used to get dividend tax credits. But Gordon Brown axed this bonus in 1997. The move is said to have cost pension funds around £5bn a year. So much for 'safely stored', then.

›› Video: Are pensions worth the effort?

Pension cons

- Not accessible until 55

This is where a pension falls down; you do not have immediate access to your cash in a time of crisis. Any money in a pension cannot be accessed until you reach 55. And even then, you will need to purchase an annuity - an insurance product that pays a set income for the rest of your life - unless you have a pretty large pot (size to be decided by the Government). [Read more on this here]

Raid: Gordon Brown made changes that cut the value of pensions over time

- They're complicated

Pensions are difficult to understand and are run in complex ways. This can be very off-putting for ordinary savers who just want to know how much they need to put aside and what they'll get back in old age.

- Government meddling

Watch out, Brown/Cameron/Blair/Thatcher (insert your PM of choice here) is about! Past governments have tinkered and fudged the pensions system to no end. It's made it difficult for savers to feel that their nest eggs are secure.

And this could keep happening, says David Thurlow: 'You can't access your pension fund until the Government says you can – this used to be 50, has recently been increased to 55 but could rise again. At present, you are allowed to take 25% of the pension fund as a tax free lump sum, but again, it is possible that a future government could abolish or restrict availability of this.'

ISAS

Isa pros

Flexible options

Isas come in two types: a cash Isas (basically a savings account) and stocks and shares Isas (a wrapper that you can either place individual shares in, or more often a fund that will pick shares and bonds on your behalf).

This is what makes Isas such winners. With both cash and shares Isas, you can get at your money as and when you want. Even fixed-rate cash Isas only see your money tied up for a few years. For those keen to ensure they can access their savings in an emergency – here's your ready-made answer.

Once your money is in a cash Isa, you will not have to talk to the taxman again. It won't be taxed as it grows and the income you take is totally tax-free.

- The 'wrapper' effect

Stocks and shares Isas act as tax 'wrappers'. As well as tax-free growth, you do not have to pay Capital Gains Tax (CGT). The only tax payable is dividend tax at 10 per cent, which applies for both basic and higher rate taxpayers. Outside Isas, higher rate taxpayers pay 32.5 per cent. And if you use a fund supermarket as your Isa 'wrapper', costs are significantly cheaper than with a pension.

Used as a source of income, Isas have certain benefits for retirees. 'The Isa really comes into it's own at the time the person decides to stop working and start drawing an income from the fund,' says Lorreine Kennedy.

Danny Cox explains: 'Tax free income from Isa has no impact on age related allowances for the over 65s, no impact on personal allowances for those with income over £100,000 and there is no requirement to record on a tax return.'

- Lasting simplicity

Simple solution: Isas let you access to your cash if you need it - good for emergencies or saving for a house but dangerous for retirement cash

You put your money in, you take your money out - it's very, very simple.

Isa cons

- No tax relief on contributions

There's no tax-back incentive as described for pensions above. So any growth isn't as powerful. 'On paper a pension will always produce a bigger fund for the same contribution because of the tax relief,' explains Danny Cox.

- Saving limits

You can only pay a maximum of £10,680 into Isas each year. You can invest all of it into a stocks and shares Isa, or save up to £5,340 into a cash Isa. These limits might well be sufficient for most people. Think about it, over the course of a 40-year working career, you can put away at least £430,000 (Isa limits rise each year by inflation), which will have grown over time. But what about those wanting to save more or who start late? Perhaps you can only afford to start saving for retirement when you reach your 40s - the limit here is serious restriction.

David Thurlow says: 'One of the biggest drawbacks with an Isa is the contribution levels. A maximum of £10,680 can be paid into an Isa each year, whereas for most people allowable contributions to pensions are much higher'.

- No employer contributions

David Thurlow of Atkinson Bolton says: 'Employers can't pay into ISAs but can pay into pensions. So if your employer will pay into your pension, it is nearly always best to receive this.'

- Means-testing while young

While you are still working, an Isa will affect most means tested benefits, such as income support, whereas a pension pot pre-retirement will not.

THE VERDICT

- Danny Cox (Hargreaves Lansdown)

'Isas provide an ideal way to grow tax-free cash savings as well as building capital by investing in the stock market. Isas are a better choice if access to savings is needed before age 55 or if 100 per cent of the capital is required at once.

'In reality, most people should spread their savings between Isa and pension, so they have funds which they can access if they need to, whilst at the same time taking advantage of the tax benefits of pension for retirement savings.

'In my view, many basic rate taxpayers should maximise their Isas before paying into pensions. The flexibility of the ISA gives it a clear edge, especially as with the pension they will get basic rate tax relief up font but end up paying basic rate tax on most of the income. For higher rate taxpayers, especially those that are likely to be basic rate taxpayers in retirement, the pension has the advantage, if you are comfortable with the inflexibility and the risk of government meddling with the rules. Where employers are paying into the pension scheme, this opportunity should be maximised.'

- Jason Witcombe (Evolve Financial Planning)

'For basic rate taxpayers my view is that Isas are generally better. With the exception of contributions made via an employer scheme, why would you tie money up in a pension for 20 per cent tax relief when the odds are you will pay at least 20 per cent tax in retirement?'

'However, higher rate taxpayers should focus more on pensions. Take an extreme example. Someone with an income of £110,000 is paying an effective rate of income tax of 60% on the top £10,000 of their income due to the loss of Personal Allowance. Paying money into a pension gets round this. Given the choice, most people would take £10,000 in their pension versus £4,000 of post tax income that they could put into an ISA.'

- Lorreine Kennedy (Care Matters)

'Anyone planning for their retirement should consider both pensions and Isas. It depends on how much you can afford to save. If you are considering contributing a modest sum of £20 per month, then perhaps a cash Isa on its own may be most appropriate route. Anyone able to save more than the annual Isa allowance should generally consider investing the excess into a pension.'

What do you think? Have the experts got it right or is there more to it? Share your views in the reader comments below...